Last week, I joined a number of economists and others in signing an open letter to Federal Reserve Chairman Ben Bernanke, urging him to discontinue the second round of so-called quantitative easing, or QE2.
I’ve signed many open letters to policy makers over the years. The response to this one was stunning. I was surprised, and remain so, that the letter was criticized so widely and so passionately as an attempt to politicize the Fed, one of the few institutions in Washington insulated from partisan fighting.
The response of David Zervos, head of global fixed income strategy for Jefferies & Co., was typical. The level-headed Zervos told clients who receive his influential commentary that our open letter was “one of the saddest moments ever for the economic profession. It is partisan politics and not sound economics.”
The history of the economics profession must be pretty sweet if this is the saddest moment ever.
Zervos and other critics are wrong for two reasons: The economic rationale opposing quantitative easing is solid, and criticizing the Fed isn’t a partisan act.
It’s true that most monetary economists accept that direct asset purchases are one of the few options left for the Fed when interest rates are close to zero. That doesn’t mean this extraordinary measure is appropriate right now.
Bernanke himself, in an Aug. 27 speech, acknowledged that “the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs” -- and that those risks and costs are uncertain.
The biggest potential benefit of QE2 is that it will reduce the risk of deflation. If prices start dropping, the economy could conceivably enter a death spiral, especially if wages don’t adjust downward as prices fall. In that case, employers might cut even more workers.
So yes, deflation risk is reduced by the Fed’s new buying program. The possible benefits of this must be weighed against significant costs.
For starters, there is the real risk that private markets will offset the Fed action and drive interest rates higher. If buyers of U.S. Treasuries decide that the U.S. is going to inflate away its debt, they might run for exits, driving risk premiums and expected future inflation much higher -- rough news for the bond market. The fact that long-term rates have moved higher in recent weeks suggests this concern is a real one.
There’s also the possibility that the Fed will have a hard time withdrawing the stimulus when inflation increases. The Fed will take big losses on its long-term bond positions if QE2 succeeds. Given how large the Fed’s balance sheet is, there’s a genuine risk that it might find its capital cushion wiped out -- which, if the Fed were a traditional bank, would mean insolvency.
This seems to trouble even one big-name Republican economist who chose not to sign the letter -- Harvard University Professor Gregory Mankiw, chief economic adviser to President George W. Bush. He wrote that QE2 is “a small but risky step in the right direction,” but also observed: “By borrowing short and investing long, the Fed is in some ways becoming the hedge fund of last resort.”
Another cost of QE2, one already playing out, is that U.S. trading partners will see an attempt to manipulate our currency and force a devaluation of the dollar. This might cause them to retaliate and could even start a trade war. Bernanke added fuel to the fire with his bellicose speech in Frankfurt last week.
Hard to Predict
Finally, the Fed’s willingness to take extraordinary action, even when the economy is growing and inflation is positive, suggests its policies will be much harder to predict in the future.
What of the argument that the letter contributed to the politicization of the Fed?
Elected officials using their power to influence monetary policy would constitute a real threat to the central bank’s independence. A letter from unelected Americans, famous or otherwise, falls far short of such a threat. The Fed’s governors might not like being criticized by a large group of policy wonks, but they enjoy the ultimate power to ignore us.
I’ll be the first to admit that the letter may have forfeited some impact because of the obvious Republican bent of the signers, some of whom, shall we say, don’t exactly spend their typical workday immersed in equations.
The politicization argument might make sense if there were some clear gain for Republicans if the Fed changes policy. There isn’t. Bernanke, remember, is a Republican, first appointed by Bush. Who’s to say Democratic economists aren’t keeping similar worries about QE2 to themselves simply because President Barack Obama is on board?
If dropping QE2, in helping the economy, also helps Obama’s re-election chances, then so be it. It’s still my best advice as an economist.
If developments in the debt and currency markets continue to prove there’s good reason to question the Fed’s course, perhaps Democrats will put together their own open letter to the Fed. If they’re interested in bipartisanship, I would be willing to sign that one too.
(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He was an adviser to Republican Senator John McCain in the 2008 presidential election. The opinions expressed are his own.)
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